V O L U M E 1 8 | N U M B E R 1 | W I NTER 2006
Journal of
APPLIED CORPORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT I O N
In This Issue: Managing Pension and Other Long-Term Liabilities
The Tax Consequences of Long-Run Pension Policy
8
Fischer Black, Massachusetts Institute of Technology and
Goldman Sachs
Allocating Shareholder Capital to Pension Plans
15
A Talk by Robert C. Merton, Harvard Business School and
Integrated Finance Limited
“De-risking” Corporate Pension Plans: Options for CFOs
25
Richard Berner, Bryan Boudreau, and Michael Peskin,
Morgan Stanley
An Investment Management Methodology for Publicly Held
Property/Casualty Insurers
36
From Stock Selection to Portfolio Alpha Generation:
The Role of Fundamental Analysis
An Investor Roundtable Sponsored by Columbia University’s Center for
Excellence in Accounting and Security Analysis
54
William H. Heyman and David D. Rowland,
St. Paul Travelers
Panelists: Andrew Alford, Goldman Sachs Asset
Management; Michael Corasaniti, Pequot Capital;
Steve Galbraith, Maverick Capital; Mitch Julis, Canyon
Capital; Andrew Lacey, Lazard Asset Management;
Michael Mauboussin, Legg Mason; Henry McVey,
Morgan Stanley; and Stephen Penman, Columbia University.
Moderated by Trevor Harris, Morgan Stanley.
How Behavioral Finance Can Inform Retirement Plan Design
82
Olivia S. Mitchell, University of Pennsylvania, and Stephen
P. Utkus, Vanguard Center for Retirement Research
Risk Allocation in Retirement Plans: A Better Solution
95
Donald E. Fuerst, Mercer Human Resource Consulting
Defeasing Legacy Costs
104
Richard Berner and Michael Peskin, Morgan Stanley
The Employer’s Role in Reforming the U.S. Health Care System
108
Kenneth L. Sperling, CIGNA HealthCare
Downside Risk in Practice
117
Javier Estrada, IESE Business School, Barcelona, Spain
New Leadership at the Federal Reserve
126
Charles I. Plosser, University of Rochester
Allocating Shareholder Capital to Pension Plans
A Talk* by Robert C. Merton, Harvard Business School and Integrated Finance Limited
G
ood evening, it’s a pleasure to be here and thank
you all for coming. It will not come as news to
any of you that adequate provision for retirement
through a combination of state, employer, and
personal savings is a worldwide concern. It’s a major concern
in Asia and South America, in the U.S. and continental
Europe, and, of course, here in the U.K. For corporations
with defined benefit (DB) pension plans, the problem has
manifested itself in a funding shortfall between pension assets
and pension liabilities. The shortfall is a consequence of the
large decline in equities in the first three years of this decade,
in combination with drops in interest rates that have raised
the value of the liabilities. The falling stock prices during that
period also coincided with—and indeed reflected—reductions in the companies’ earnings and hence in their ability to
fund their shortfalls out of business operations.
The new accounting treatment of pensions in the U.K.—
a version of which is now being considered by the FASB
in the U.S.—will make these shortfalls more transparent
to interested parties, particularly investors, rating agencies,
and regulators. And as the new rules come into force, they
are likely to have real effects, such as limiting dividends and
other distributions to shareholders. Some companies are
responding by capping or shutting down their DB plans,
and then creating defined contribution (DC) plans. 1
There are of course multiple facets to this very important issue. My remarks this evening will focus primarily on
the corporate challenge of providing retirement income to
employees while limiting the costs and risks of retirement
plans to the firms, and ensuring that investors and rating
agencies understand both the risks and corporate efforts to
deal with them. My main focus throughout will be on the
real economic import and consequences of such issues and
not how they are reflected on financial statements. This is
not to suggest that accounting issues are unimportant, only
that accounting is not my expertise—and because I value
the time you are spending with me, I will concentrate on
what I know a bit more about.
In the rest of this talk I will address five questions:
• What are the major issues and challenges surrounding pensions? We all know that the shortfall has been the
focus of attention. However, I will make a case that while
the gap between assets and liabilities is important, of far
greater concern for the future is the risk mismatch between
pension assets and pension liabilities. Most U.K. and U.S.
companies have been funding debt-like liabilities with
investments in equity-heavy asset portfolios. 2
• To what extent do the equity market and equity prices
reflect the shortfall in pension funding and the mismatch in
risk? Do the markets see through the smoothing of pension
earnings by accounting convention and consider pension
shortfalls and mismatch risks in valuing the equity? What
does the evidence tell us? Moreover, even if the market
appears capable of reflecting pension risk, is it possible that
analysts’ P/E multiples and management’s assessments of
cost of capital are distorted by failure to take full account of
the risks associated with pension assets?
• How should management analyze and formulate
strategic solutions? I will offer no specific solutions tonight
because each firm faces somewhat different circumstances
and no one prescription fits all. Nevertheless, I do want to
lay out a framework for analyzing the problem from a strategic perspective that can be used in formulating a company’s
pension policy. In particular, I will recommend that companies take an integrated perspective that views pension assets
and liabilities as parts of their economic value and risk
balance sheets—and one that accordingly treats the pension
asset allocation decision as a critical aspect of a corporatewide enterprise risk management program. Finally, I will
offer the concept of a risk budget—basically, a list of all of
a company’s major exposures along with an estimate of the
amount of equity capital necessary to support each one. One
important use of such a risk budget is to enable management
to address the question of how much equity capital must be
allocated to the risk positions, or risk mismatches, that are
created by asset allocation decisions in DB pension plans.
* This is an edited transcript of a speech delivered in London on October 21, 2004 at
a conference on pensions sponsored by BNP Paribas. Some events that have occurred
since that time are reflected in the footnotes that have been appended to the talk.
1. IBM’s recent announcement of its shift to a DC plan could turn out to be a watershed
event that precipitates the unraveling of the DB system. If healthy and employee-centric
companies are getting rid of DB plans even for existing employees, what kind of compa-
nies are going to pay ever larger premiums to remain part of the system insured by the
Pension Benefit Guaranty Corporation?
2. One notable difference between U.S. and U.K. companies is that the latter provide
workers with inflation-indexed benefits, and such benefits can be immunized with inflation-linked “Gilts.”
Journal of Applied Corporate Finance • Volume 18 Number 1
A Morgan Stanley Publication • Winter 2006
15
• The fourth question has to do with issues of implementation. If a company chooses to make a major change
in its pension policy, such as a partial or complete immunization accomplished by substituting bonds for stocks, how
would you communicate the risk implications of the new
policy to the rating agencies and investors? How would your
approach be affected by whether your plan is fully funded,
underfunded, or overfunded? If underfunded, should one
borrow to fully fund the plan?
• The fifth and final section discusses the challenges
associated with moving from a DB plan to a defined contribution, or DC, plan. What are the major issues to be
thinking about when contemplating such a change?
I will confess to you at the outset that most of the
examples I will discuss come from the U.S. rather than
the U.K. The only defense I offer for such provincialism
is to plead my own familiarity with U.S. companies and
numbers. But let me suggest that most of the U.S. cases
I will present have rough counterparts in the U.K.—and
that if you make some effort to translate the numbers and
the circumstances into a U.K. context, I think you will find
that the main issues that I raise tonight apply, with roughly
equal force, to U.K. companies.
$1 invested in bonds. This mistaken way of thinking,3
which is effectively embedded in pension accounting and
actuarial smoothing of pension returns, has been a major
driver of corporate pension allocations. What such thinking ignores, of course, are the very different levels of risk
associated with the higher expected returns on equities, a
reality that became very clear during the market experience
of 2000-2002.
The Real Issue—Risk Mismatch
The Apparent Issue—Funding Shortfall
The funding shortfall has been the focus of analysts, the
rating agencies, (which have treated the shortfall as a form
of debt for at least a decade), and regulators. You heard the
numbers in my introduction; these are big numbers and the
problem needs to be addressed. But I have no magic solution if you are underfunded by $1 billion; I cannot tell you
how to wave a wand or give you a strategy that makes the
underfunding disappear in true economic terms. And just to
be clear, when I say “underfunded,” I mean that the current
marked-to-market value of the pension assets is less than the
current marked-to-market value of the pension liabilities.
Underfunding has long been a problem, though it was
largely hidden in the 1990s. This was partly driven by a
mistaken tendency to equate higher expected returns with
higher realized returns. Like most economists, I agree that
equity returns in general are expected to be higher than
fixed-income returns. However, the concept of higher
expected equity returns has been translated, thanks to a
misapplication of actuarial science, into the statement,
“For companies with a long enough time horizon, higher
expected returns can be assumed to imply higher realized
returns for certain.” And from there it is a short step to the
idea that $1 invested today in stocks is worth more than
But, again, I believe that the biggest pension problem facing
Corporate America and its investors is not the shortfall, but
the risk mismatch between pension assets and liabilities.
Suppose you were looking at two companies. For Company
A, the ratio of its pension assets and liabilities on a markedto-market basis is 1.0. For Company B, the ratio of assets
to liabilities is 1.05 to 1.0. Which company should we be
more worried about? With no other information about the
companies or their plans, common sense of course says that
the firm that is 5% overfunded is in a better position.
But let me now give you the rest of the story. Company
A’s allocation of pension assets is to choose 100% bonds
with the same duration as its pension liabilities. Company
B has 85% of its pension asset portfolio in equities. Now,
which of the two should you watch more closely? The point
I’m making with this simple example is that balance sheet
numbers, whether marked-to-market or not, are static and
therefore of limited use. They are a picture of where the
firm and its assets and liabilities are right now. They reveal
nothing about the risk that those two numbers may change,
either by how much or with what likelihood.
In the first case, as long as Company A maintains
its policy, even though the plan is just fully funded, that
funding will be completely adequate; you do not need to
be overfunded if you always hold assets that precisely hedge
the risk of the liabilities. In the second case, however, even
a funding ratio of 1.05 is probably not sufficient. While it
is quite true that the company’s funding ratio could jump
from 1.05 to 1.20 in a year’s time, it could just as quickly fall
to 0.85. The balance sheet numbers that purport to measure
a pension surplus or deficit give no indication of risk.
The risk mismatch is likely to be of greatest concern in
cases where the ratio of pension assets to the market capitalization of equity is high. For publicly traded U.S. companies with
DB pension plans near the end of 2001, the median ratio of
pension assets to the market cap of equity for the top quintile
of firms (ranked by that ratio) was 2-to-l.4 That underscores
the point that pension assets are not small relative to the total
3. The fallacy of treating expected stock returns as risk free has been demonstrated
by Paul Samuelson in several of his writings: “Lifetime Portfolio Selection by Dynamic
Stochastic Programming,” Review of Economics and Statistics 51 (1969); and “The LongTerm Case of Equities and How it Can be Oversold,” Journal of Portfolio Management
(Fall, 1994); and, more recently, by Zvi Bodie, in “On the Risk of Stocks in the Long Run,”
Financial Analysts Journal (May-June, 1995). As discussed later, still another way of dem-
onstrating this fallacy is to note that a 40-year return asset return swap in which one receives the cumulative total return on the S&P 500 over 40 years and pays the cumulative
return on either UST bills (rolled over) or UST 10-year bonds can be purchased for $0.
4. For the pension quintile ratios of pension assets to market cap, I am indebted to a
presentation by Michael Gilberto of J.P. Morgan Chase at a JPM Investment Management
Conference on October 4, 2001.
16
Journal of Applied Corporate Finance • Volume 18 Number 1
A Morgan Stanley Publication • Winter 2006
equity of the firm. Moreover, it is typical to have 60% to 70%
of the pension assets in equities. This means that for at least
20% of the companies in this sample, the equities holdings in
their pension portfolios are larger than the entire market cap
of the firm’s equity (60% of 2.0 is 1.2).
Take the case of General Motors, which has the largest
corporate pension fund in the U.S., with total assets of
approximately $90 billion. If we assume that 65% of those
assets are devoted to equities—which, again, is standard U.S.
corporate practice—that means the company has approximately $60 billion invested in equities. At the moment,
GM has a market cap of approximately $22 billion, which
means that it may well have almost three times its own
market cap invested in the equities of other companies.5
Even for large firms, if you are thinking in terms of the size
of the pension investment versus such things as the amount
of equity capital, this is quite considerable. We need to be
aware of that in our thinking.
Now consider a corporate balance sheet that includes
$60 billion of equity on the asset side and a $60-billion
liability that is perfectly matched in terms of value but not
risk. This mismatched combination of assets and liabilities
would not show up any differently on accounting statements—even under the new IAS rule—than $60 billion of
debt assets that were perfectly matched in risk to the pension
liability. The first of these two combinations is equivalent to
making a $60-billion bet on the stock market and financing
it with $60 billion of fixed-rate, long-term debt. For those
of you who are familiar with derivatives, this is equivalent
to entering into a $60-billion asset return swap where you
pay a fixed rate of interest in return for receiving the total
realized market return on equities.
Recognizing the Risk
As you know, when a swap is first done on standard terms, it
has essentially no value; in terms of the balance sheet, it thus
has no entry. What about its risk? Would you say there is a
fair amount of risk if you bought $60 billion of equity and
financed it with $60 billion of fixed-rate debt? That is a huge
risk position. I am not saying that risk-taking is wrong, but
failing to recognize the size of that risk position is a mistake.
Imagine a CEO, accompanied by his or her CFO or finance
director, announcing to an audience of shareholders, creditors,
and other stakeholders, “Our current market capitalization is
$15 billion. Our strategy for the coming year is to buy $60
billion of equities and finance the purchase with $60 billion
of long-term fixed-rate debt.” I think that recommendation
would evoke a considerable amount of discussion.
And this brings me to the issues of transparency and
framing. I am not suggesting that companies are consciously
5. Although GM recently reported that the 2005 gains in its pension fund have given it a
pension surplus of some $6 billion, the economic reality—again based on the assumption
that 60% of the fund is in equities—is that the VaR or equity capital necessary to support
Journal of Applied Corporate Finance • Volume 18 Number 1
attempting to mislead investors about their pension policies.
What I am trying to emphasize is the importance of
acknowledging the economic reality that the pension assets
are the shareholders’ assets, and then framing the risks
accordingly. Pension assets are “encumbered” assets in the
sense that there is a lien against them by the pensioners in
the plan, but the residual gains and losses from that pension
asset portfolio basically flow to the shareholders.
Now, there is one important exception to this rule—
namely, companies with pension deficits facing a significant
probability of default and bankruptcy. Since the pension
losses of such firms are likely to end up being borne by the
Pension Benefit Guaranty Corporation in the U.S.—and
by the Pension Protection Fund in the U.K.—the valuemaximizing strategy may well be to maintain and even
enlarge the risk mismatch of their pensions in the hope that
large pension gains can help rescue the firm by covering the
shortfall and limiting future contributions to the plan. But,
for reasonably healthy companies, pension assets are effectively (though not institutionally) assets of the corporation;
and pension liabilities are liabilities of the corporation, no
matter what happens to the pension assets. It is an obligation of the corporation, much like payments of interest and
principal on its debt.
In this sense, then, pension risks are corporate risks.
And as I discuss in more detail later, how one frames the
risks in corporate DB plans will affect corporate decisions
to continue or modify such plans as well as the choice of
assets to fund them. When you consider the magnitude
of the total value changes stemming from the mismatch
of risk, it becomes very clear that the mismatch is a bigger
problem than the current shortfall in funding. For companies with large DB plans, the impact on corporate values of
a recession-induced drop in equities combined with a drop
in interest rates—a combination similar to what we saw
during the first years of this decade—could end up dwarfing the effects of a downturn on the operating businesses.
The risks associated with today’s pension asset-liability
mismatches are very big risks indeed.
Accounting for Value Mismatch and Risk
My second major point has to do with how the markets seem
to take account of both the value mismatch—that is, the size
of any pension surplus or shortfall—and the risk mismatch.
In terms of value, research done over a decade ago at the
National Bureau of Economic Research on U.S. companies—and I have no reason to think it would be materially
different for U.K. companies—supports the idea that share
prices do in fact reflect the value of pension surpluses or
shortfalls. In particular, companies with large pension defithat risk exposure is several times the firm’s current (January 24, 2006) equity market
cap of $13 billion.
A Morgan Stanley Publication • Winter 2006
17
cits appear to trade at lower P/E multiples and price-to-book
ratios than firms with fully or overfunded DB plans.6
This finding did not come as a surprise. But I have to
confess to some surprise at the findings of some recent work I
did with colleagues Zvi Bodie and Li Jin on the value effects
of pension risk mismatch.7 And let me remind you once
more of the proposition we were testing: You could have a
pension plan in which pension assets and pension liabilities
are roughly equal in value, meaning there is no shortfall or
surplus. But if the pension assets were largely in equities
and the liability is largely fixed-rate debt, the risk exposure
would be huge. And the question we were attempting to
answer in our study was: Does the market capture that risk?
Given the arcane accounting and institutional separation
between the pension plan and the rest of the business, I did
not think the market would take it into account.
But our results suggest that, during the period of our
study8—1993 to 1998—the U.S. stock market did a pretty
good job of picking up the differences in risk. More specifically, a company with a larger fraction of equity in its pension
portfolio tended, all other things equal, to have a larger
“beta”—a widely used measure of risk that reflects, among
other things, the “systematic-risk” volatility of the stock
price itself. In other words—and this is simplifying things
a bit—the greater risk associated with equity-heavy pension
plans seemed to show up in more volatile stock prices.
What’s especially interesting to me about these findings
is that they apply to a period that preceded the large
market decline that started in 2000. It’s relatively easy to
see how investors could become sensitized to the possibility of pension losses during a market downturn. But the
evidence of our study seems to show that share prices do
take account of pension risk, even when most pensions are
in surplus—and when the risk shows up nowhere on the
accounting balance sheet. And to the extent the marketplace charges firms for bearing that added pension risk, our
findings have some important implications for corporate
policy and investment decisions that I will discuss later.
To repeat my point, then, our evidence comes not from
surveying analysts, but from looking at what actually happens
to share prices. And this, of course, is supportive of the idea
of an efficient stock market. But we are not out of the woods
yet. It is entirely possible that some equity analysts do not pay
much attention to pension risk when assessing P/E multiples
and comparing companies. It’s also possible that some corporate managers may not be taking account of the contribution
of pension risk to overall corporate risk when making major
capital allocations among their different businesses. And, as
discussed below, the result could be distortions of both analysts’
valuations and strategic corporate business decisions.
6. See, for example, Martin Feldstein and Stephanie Seligman, “Pension Funding,
Share Prices, and National Savings,” Journal of Finance, Vol. 4 No. 36 (1981).
7. See Li Jin, Robert C. Merton, and Zvi Bodie, “Do a Firm’s Equity Returns Reflect the
Risk of Its Pension Plan?” forthcoming Journal of Financial Economics.
8. In 1993, companies were required for the first time to report ERISA form 5500,
which provides a list of the firm’s pension holdings as of year end.
9. For illustrative purposes, all the calculations of the effect of the pension plan on beta
estimates for WACC are based on the assumption that corporations do not pay income
taxes. In practice, companies need to incorporate into their WACC analysis an estimate
of the company’s marginal corporate tax rate. If the company is and expects to be fully
taxable at all times, a portion of the value of the pension assets and the pension liabilities
are “owned” by the government and so therefore are their risks. But that computation is
very firm-specific and not required for the level of demonstration here.
18
Journal of Applied Corporate Finance • Volume 18 Number 1
Calculating the Weighted Average Cost of Capital
To illustrate this point, let’s say you are a corporate executive
considering a decision to expand into more or less the same
business you are in now. In that case, the standard capital
budgeting approach is to estimate the expected future cash
flows and then discount those flows at the firm’s weighted
average cost of capital (WACC). How do you get estimates
of your WACC? If you are a publicly traded company, you
can typically observe the historical movement of your share
prices, and then estimate the beta of the share returns.
When you do this, you are really assuming that the historical volatility of the stock is a reliable proxy for its risk—and,
in this sense, beta is a wholly market-based measure of risk.
The market may be completely wrong about this, but this is
how investors perceive the risk of your stock.
Now, in valuing a project, unless the firm is financed
entirely with equity, you cannot simply take the firm’s beta
and come up with a cost of equity capital. You have to take
account of the use of debt in the firm’s capital structure. To
do that, you “de-leverage” the equity to come up with the
WACC, which is an average of your debt and equity rates;
you get the equity rates from the riskiness measured historically. Your debt rates are your observed debt rates. That is
standard procedure for estimating WACC.
But the use of WACC to evaluate this project is based
on a couple of important premises. First, as mentioned, the
project in question should have roughly the same operating
risk and be able to support the same leverage ratio as the
rest of the firm’s assets. Second, the calculation of the firm’s
leverage ratio should reflect all senior corporate obligations,
not just on balance-sheet debt. 9
Incorporating Pension Risk Into WACC
Given our focus on pension assets and liabilities, this
suggests there may be a problem with this standard procedure for estimating WACC: its failure to take account of
the risk of other important assets that are not reflected on
GAAP balance sheets. As we have already seen, pension
assets can be a significant fraction of total corporate assets.
And for companies with large DB plans, an equity-heavy
asset portfolio can be one of the main sources of total volatility on the left side of the balance sheet—in some cases as
large as the operating business itself.
A Morgan Stanley Publication • Winter 2006
Table 1
Errors in Estimates of Weighted Average Cost of Capital: Examples
Boeing
DuPont
Eastman Kodak
Textron
Pension
Assets
($bn)
Pension
Liabilities
($bn)
Pension
Surplus/
Deficit ($bn)
Market Cap
($bn)
33.8
17.9
7.9
4.5
32.7
18.8
7.4
3.9
1.1
(0.9)
0.5
0.6
30.9
42.6
8.6
5.9
Book Value
of Debt
($bn)
12.3
6.8
3.2
7.1
Standard
WACC*
WACC Adjusted
for Pension
Risks*
8.80%
9.44%
9.75%
7.98%
6.09%
8.15%
7.47%
6.81%
* WACC numbers are based on a risk-free rate of 5% and a market-risk premium of 7%.
Taken from “The Real Problem with Pensions,” Harvard Business Review, December 2004.
On the other side of the balance sheet, pension liabilities
are missing from the standard procedure as well. Pension
liabilities are debt. Though collateralized by the pension
assets, they are an obligation of the firm and thus part of
the leverage or gearing of the firm.
By failing to take account of their pension assets and
pension liabilities when estimating their cost of capital,
companies are probably distorting their measures of operating, or project, risk in two ways. First, they are effectively
assigning the firm’s total risk to its business operations, when
a potentially significant part of that risk could in fact come
from the pension fund assets. Second, because the standard
analysis does not take account of the pension liabilities, it
understates the firm’s leverage ratio.
The typical effect of these two distortions is to overstate
WACC for an operating project. If our analysis instead used
a pension-adjusted leverage ratio and included the pension
assets on the left-hand side of the balance sheet, the resulting estimates of “unleveraged” operating beta for most
companies with large DB plans would fall.
To sum up, then, if management estimates WACC by
the standard method, it can lead to a major distortion of
the capital allocation decision. It means applying too high
a hurdle rate to projects, which means the firm may not
undertake all the projects that are expected to increase its
value. Taken by itself, it does not imply anything about the
optimal asset allocation in the pension fund plan; but it is
one possible consequence of not taking account of it.
Illustrations
To give you an idea of how big that distortion could be for
some real companies, let’s look at four examples: Boeing,
DuPont, Eastman Kodak, and Textron.10 As shown in Table
1, all but DuPont have pension surpluses. And DuPont’s
pension shortfall is tiny compared to both its total liabilities and assets, and to its market cap. These are financially
healthy companies; they are surely not high on anyone’s list
of the type of pension issues that normally concern us.
Calculating a standard WACC, which fails to take
account of the risk of the pension assets and the gearing of
the pension liabilities, leads to an estimated cost of capital
for Boeing of 8.8%. But when we make an adjustment for
the company’s pension risk that reflects the extent of its assetliability mismatch—and take account of the size of the pension
liabilities, which changes the firm’s leverage ratio—Boeing’s
estimated WACC drops to about 6%, implying an overstatement of almost 300 basis points by the standard methods.
That is the extreme case in the sample, but estimates of the
overstatements for all four firms exceed 100 basis points.
This is not to say that the managements of these four
companies are actually making this mistake; I have not
worked with any of these companies and have no knowledge of their capital budgeting process. What I am saying
is that if they follow the standard textbook procedure for
estimating WACC, without adjusting for the risk and size
of the pension fund, they could be materially overstating
their cost of capital. And since we know that stock-price
multiples are roughly inversely related to required returns
or cost of capital, analysts who are overstating the estimates
of cost of capital are also likely to be underestimating the
multiples of the companies they cover.
In sum, pension decisions in terms of both asset size
and allocation have the potential to affect the management
of the entire firm at the most fundamental level. Strategic
investment and risk-management decisions can be affected
by the allocation of pension assets. And for reasons I’ve
just illustrated, the failure of corporate managements to
view pension assets and liabilities as part of the firm may
well be leading to underinvestment in the operating part of
the business.
Strategic Analysis and Policy Development
My third major point is about strategic analysis and working
toward developing a pension plan policy. I hope the preceding remarks have demonstrated the need for an integrated
enterprise-wide approach, one that views pension assets and
liabilities as parts of the firm’s comprehensive economic and
risk balance sheets. To evaluate their sources and impact
10. These examples appear in Lin, Merton, and Bodie, forthcoming JFE, cited above.
Journal of Applied Corporate Finance • Volume 18 Number 1
A Morgan Stanley Publication • Winter 2006
19
Table 2
Effect of Pension Asset Risk Mismatch on Equity Risk and Cost of Capital:
LT Corporation (with Fully-Funded Pension Plan)
Standard Balance Sheet Estimates
Value ($bn)
Risk (Beta)
Value ($bn)
Risk (Beta)
Operating Assets
$40
1.05
Debt
Equity
$19
$21
0.00
2.00
Total Assets
$40
1.05
Total L&E
$40
1.05
Estimated WACC Operating Assets = 12.35%
at the strategic level, pension risks should be evaluated not
only in terms of implementation of the pension plan, but
within the context of the firm’s other objectives, risks, and
strategic plans, including effects on credit ratings.
Or to turn this thought upside down, all of a company’s
major business and financing decisions should be informed
by a well-structured analysis that views capital allocation,
capital structure, and pension plan decisions as parts of an
integrated strategy. Much of my emphasis to this point has
been on the potential effects of pension asset allocation on
corporate capital allocation and capital structure choices. It
is precisely because of these effects—of this linkage between
the pension and the operating business—that pension asset
allocation should be considered a strategic issue, one that is
overseen at the highest level of corporate decision-making.
But if we continue to view the pension fund as an offbalance sheet entity with no ties to the firm, our decision
making will likely also continue to be distorted by the higher
expected returns on equities, even if the new accounting
rules force us to report actual rather than expected returns
in our financial statements. After all, shifting pension assets
from equities to bonds will lower the expected returns on our
asset portfolio and raise the contributions needed, at least in
the near-term, to meet plan obligations. And that sounds
like a bad thing, a value-reducing proposition—until one
begins to consider the effect on risk. When you look at the
whole picture, lowering the expected returns on the assets
also lowers the risk of the entire firm. And by lowering risk,
you create the capacity for the firm to take other risks—core
operating risks, if you will, that are likely to add more value
than passive equity investments in other companies.
That brings me to the concept of a “risk budget” I
mentioned earlier. I find it useful to think of companies as
having risk budgets that are very much analogous to their
capital budgets. Reducing risk in one place releases capacity
to increase risk elsewhere without having to add more equity
capital to the firm. And this means that the total opportunity created by reducing risks in the pension fund is to
enable the firm to take more risk in its operating businesses,
which is presumably where it is most likely to find positive
20
Journal of Applied Corporate Finance • Volume 18 Number 1
net present value opportunities. The expected net effect of
such changes is an increase in firm value. Although you
reduce the expected return on your pension assets, you gain
more from the new operating assets that you are now able
to hold without additional equity capital—all of which is
made possible by the reduction of risk in the pension fund.
Having said this, let me also hasten to add that 100%
bonds will not be the optimal pension portfolio for all DB
plans. But the possibility for such gains from reducing
pension risk is a good reason to view your pension assets
and liabilities as part of an enterprise-wide risk framework.
As with any other decision that affects corporate balance
sheets or income statements, changes in pension strategy
and risk are bound to show up somewhere else. And, as I
said a moment ago, it is because of their effects on the rest of
the firm that pension decisions must be overseen by decision
makers at high levels in the corporate organization, people
entrusted with managing the risks and maximizing the
value of the entire enterprise.
An Illustration
As a hypothetical illustration of how to evaluate the risk of
a company’s operating assets and its pension plan, let’s take
the case of a company called LT. Table 2 provides standard
balance sheet estimates of operating asset risk and WACC,
without considering the pension plan. All numbers are
market values, not book values. We arrived at the value of
the operating assets by taking the market value of equity
and the market value of debt—$21 billion and $19 billion,
respectively—and adding those up to arrive at $40 billion,
which is equal to the value of total assets.
To do a conventional calculation of WACC for LT,
we began by estimating its beta from historical market
returns—and our estimate turned out to be 2.0. Then,
taking account of the firm’s debt and its level of risk, we
determined that the weighted risk of debt and equity results
in an “unleveraged” or “asset” beta of 1.05. If LT’s management team were using this method to evaluate a project
similar to the company’s other operations, the project would
be valued using a WACC based on a risk factor of 1.05.
A Morgan Stanley Publication • Winter 2006
Table 3
Effect of Pension Asset Risk Mismatch on Equity Risk and Cost of Capital:
LT Corporation (with Fully-Funded Pension Plan)
Full Economic Balance Sheet Estimates
Value ($bn)
Risk (Beta)
Value ($bn)
Risk (Beta)
Operating Assets
Pension Assets
$40
$46
0.36
0.60
Debt
Pension Liabilities
Equity
$19
$46
$21
0.00
0.00
2.00
Total Assets
$86
0.49
Total L&E
$86
0.49
Estimated WACC Operating Assets = 7.52%
Using a risk-free rate of 5% and a market-risk premium of
7%, we would come up with a WACC of around 12%.
In Table 3, we show what happens when you adjust the
conventional analysis to incorporate a full economic balance
sheet—one that takes account of risk as well as value and
so includes the pension assets and pension liabilities. The
pension plan is fully funded—$46 billion of assets and $46
billion of liabilities—and since there is no surplus or shortfall, there is no entry on the traditional balance sheet. Since
60% of the pension assets are invested in equities, LT does
have a significant risk exposure to equities; but, again, that
exposure is not recorded on its GAAP balance sheet. When
we expand the balance sheet to include the pension assets
and liabilities, we have a much larger company—$86 billion
of total assets instead of $40 billion, and $65 billion of total
debt instead of $19 billion. We can easily estimate the risk
of the pension asset portfolio—a well-diversified portfolio of
equities and debt—just by looking at its composition: If we
assume that the stocks have a beta of 1.0 and the bonds have
a beta of 0, a portfolio with 60% equities can be assumed,
pretty much by definition, to have a beta of 0.60.
The next step, then, using the firm’s equity beta of 2.0,
is to use LT’s leverage ratio and its pension assets and liabilities to “back out” the firm’s operating asset risk, which turns
out to be 0.36. In this particular case, then—perhaps an
extreme one, but useful in making my point—the operating
assets actually have a materially lower systematic risk than
the pension fund assets! 11 Moreover, when we evaluate the
total asset risk, which includes the risk of both the operating assets and the pension assets, we get 0.49, which is less
than half the estimate we came up with—1.05—doing the
analysis the conventional way.
But for purposes of project valuation and capital
budgeting, the relevant comparison for LT’s management
in this case is not between 1.05 and 0.49, but between 1.05
and 0.36. If we were to do a capital budgeting analysis of
contemplated projects for LT’s core business, we would use
0.36 in calculating WACC; and if we did so, the cost of
capital would fall from over 12% to 7.5% (5% + {0.36 x
7.0}). For projects with an expected life of ten years, the
effect of overestimating the discount rate by some 450 basis
points can be an underestimation of project values on the
order of 30-40%. And as this example is meant to suggest,
neglecting the risk of the pension plan can lead to major
distortions of the capital budgeting process.
Besides improving capital allocation decisions, use of this
expanded balance sheet approach provides a better picture of
your firm in terms of its value and risk allocations between
your operating businesses and other activities such as pension
asset investments, which are largely passive investments. Your
pension plan may make use of active fund managers; but
unless you are a financial firm, managing financial assets is
probably not part of your core business. Use of an expanded
risk balance sheet can give top management a better picture of
the composition and risk character of the firm.
11. This is in fact not uncommon for the kind of companies that have DB plans—
in many cases, basic industrial companies with relatively low betas.
12. But if the firm also maintains its total risk posture by simultaneously issuing
new debt and using the proceeds to buy back stock, the effect on EPS is not clear; EPS
could increase.
Journal of Applied Corporate Finance • Volume 18 Number 1
Considering Alternative Pension Policies
Now I will try to show how the economic and risk balance
sheets from Table 3 can be used to explore alternative
pension asset allocation policies and their implications for
capital structure and firm risk. Before I go any further, let
me warn you that I’m not offering a specific policy recommendation for LT or any other firm. What I’m presenting is
a framework for thinking about the effects of different asset
allocation on the risk of the enterprise.
The conventional analysis of a change in pension asset
allocation—say, a major shift from stocks to bonds—focuses
mainly on the effects of the change in expected return on
corporate balance sheets and income statements. At least
from the vantage point of GAAP—though less so with the
new U.K. standard—the primary effect of such a change is
to reduce reported earnings. 12 In addition to such account-
A Morgan Stanley Publication • Winter 2006
21
Table 4
Effect of Pension Fund Asset Allocation on Asset and Equity Risk: LT Corporation
Fraction of Pension
Assets in Equities
Pension Asset Beta
Total Asset Beta
Firm Equity Beta
0.00
0.25
0.60
0.75
1.00
0.00
0.25
0.60
0.75
1.00
0.17
0.30
0.49
0.57
0.70
0.70
1.23
2.00
2.34
2.88
ing effects, conventional analysis also takes account of any
effects on the stand-alone risk of the pension fund.
The main focus of economic analysis, however, begins
with the changes in risk. When a company alters the mix of its
pension assets between fixed-income and equities, it changes
its equity risk and the risk of the overall firm. For example, as
can be seen in Table 4, if LT were to raise its pension allocation of equities from 60% to 100%, our analysis suggests that
the firm’s total asset risk factor would increase from 0.49 to
0.70—a significant increase in the risk of the total company.
And the beta of the firm’s equity is estimated to jump from
2.0 to 2.88—though, again, I ask you not to take the precision of these numbers seriously. In this case, you see nearly a
50% increase in the risk of the firm’s equity. Investors require
a higher expected return for this kind of increase in risk.
Now, let me also say that such an increase in risk is not
inherently bad. What is important, however, is to understand the change and any possible firm-wide effects.
A decision to go to 100% equities, though not necessarily a bad idea for all companies, does mean a higher return
requirement by your equity holders. When you think of
the higher expected return on the equities in your pension
fund, the good news is that you can indeed expect them
to produce higher returns, at least over a sufficiently long
time horizon. The bad news, however, is that because of the
risk associated with your pension assets, your own shareholders will demand a higher return than they did before
and lower the P/E multiple on your stock. So, even if your
future pension contributions turn out to be lower and your
reported earnings higher as a consequence of an all-equity
pension, the reduction in your multiple may leave your stock
price unaffected or even lower than otherwise.
But, again, I am not offering a specific prediction or
recommendation here. My purpose is simply to show how
overall firm risk and its equity risk are influenced by pension
asset allocation, and to note that such changes could end
up increasing the firm’s cost of capital and lowering its
multiple. Neither of these effects is necessarily bad, but you
should prepare yourself for the probable changes.
Effects of Pension Change on Optimal Capital Structure
As we change the pension asset allocation, what are the
implications for the capital structure or the amount of equity
22
Journal of Applied Corporate Finance • Volume 18 Number 1
capital required to keep the risk of our equity unchanged?
Let’s return to the case of LT, and assume that the company’s management and shareholders are comfortable with
their current equity risk factor of 2.0. Let’s further assume
that one of the firm’s key risk management objectives is to
maintain the beta risk of its equity at that level.
As we saw in Table 4, an increase in the allocation of
pension asset to equities increases the risk of the total assets.
And if we increase the risk on the left-hand side of the balance
sheet, in order to keep the risk of our equity unchanged we
have to reduce leverage or gearing. If you increase asset risk
and leave the capital structure unchanged, equity risk goes
up. Another way of saying this is that, for your creditors
and equityholders to be as comfortable as they were before
the pension change, any increase in asset risk will have to be
offset by taking less risk with your capital structure. There
is no free lunch in that sense.
Table 5 provides an indication of how much equity
capital the firm would need to maintain an equity risk of
2.0 for a range of pension asset allocation choices. We begin
with the assumption that LT’s management and shareholders are comfortable with the status quo, at least in the sense
that the combination of a 60% pension equity allocation
with $21 billion of shareholders’ equity meets the firm’s risk
management criterion of maintaining an equity beta of 2.0.
But, according to Table 5, if management took the extreme
step of increasing the pension allocation to 100% equities,
the firm would have to issue $9 billion of new equity in
order to maintain the same risk for LT’s equity holders. In
other words, to keep its equity risk the same, the firm would
have to deleverage or reduce the gearing by $9 billion; and,
as shown in Table 5, its debt-to-equity ratio would drop
from 0.9 to 0.33. At the other extreme, if the firm were to
shift the entire pension into bonds that perfectly match the
pension liabilities, the amount of equity capital needed to
keep the equity risk at 2.0 would fall to $7 billion from $21
billion—and the debt-to-equity ratio would rise above 4.0.
Cushioning your Risks with Capital
Tables 4 and 5 provide just two illustrations of how, once
you have set the analysis up correctly, you can begin to
discuss pension asset allocation in an integrated way, taking
into account the impact you are having on the capital strucA Morgan Stanley Publication • Winter 2006
Table 5
Tradeoff Between Pension Asset Allocation and Firm Capital Structure
Fraction of Pension
Assets in Equities
Total Asset Beta
Firm Equity Beta
0.00
0.25
0.60
0.75
1.00
0.17
0.30
0.49
0.57
0.70
2.00
2.00
2.00
2.00
2.00
ture and risk of the business. You can use this tool to ask
how much capital you are holding in the firm to cushion
the risk mismatch of the pension fund versus the amount
needed to support the risk of the operating businesses.
You are not going to trade on the precision of these
numbers, but the magnitudes and implications here are
essentially valid and will stand up to more sophisticated applications. In fact, my firm IFL has done this kind of analysis for
clients who were surprised to discover how much of their total
risk, and therefore the total amount of capital allocation, had
to do with the risk mismatch in their pension fund.
Does this say that all companies should immunize their
pension liabilities and thus avoid a risk mismatch in your
pension fund? The answer is no.13 Our analysis says only
that you should understand how much risk your shareholders are bearing as a result of the mismatch, how much capital
you are using to support it, and how your cost of capital is
affected by it. An integrated approach requires you to look
at all of these factors and consider all the choices that can be
made. And when you do that, you are in a position to make
an informed strategic decision.
Implementation
When you have done this analysis and decided on a pension
policy, you then have to decide how to communicate that policy
to the rating agencies, to your shareholders, to analysts, and to
others. We believe that a good way to do that is to provide a
full reasoned analysis in support of your new policy, one that
includes a demonstration of how much risk-reduction credit
you expect to get from changing a 60% equity allocation to, say,
one of 25%. If you accept the numbers in the LT example, for
example, you could eliminate almost $8 billion in equity.
But that estimate would simply provide a starting point
for your discussion. You would then have to see how much
13. Immunization of the pension liabilities, although the value-maximizing approach in
many cases, will not always be the optimal solution. The problem with current immunization
practices, or those that now go under the name “LDI,” is that they apply ALM only with
respect to the pension assets and pension liabilities alone instead of considering ALM with
respect to the assets and liabilities of the entire corporation.
When determining an optimal policy, one must define the objectives and conditions under
which you are assessing alternative pension fund policies. If you frame the problem as: What
provides the maximum assurance to plan participants of the benefits that they have accrued
in a plan that is currently fully funded (to the level of the ABO at true marked-to-market valuations) and that will continue to be fully funded as future benefits accrue pari passu with
the existing benefits of the plan, the answer is indeed immunization. This particular framing
takes as given the amount and terms of the promised benefits and assumes that the firm
Journal of Applied Corporate Finance • Volume 18 Number 1
Equity Capital ($bn)
7.3
12.9
21.0
24.5
30.1
Debt/Equity Ratio
4.48
2.10
0.90
0.63
0.33
the rating agencies would actually allow you to reduce equity
without affecting the rating when you show them how much
risk you are taking out on a permanent basis. This is an unsettled question, and the answer to it can be expected to change
over time as the rating agencies and credit markets develop
greater understanding of pension risk and its effect on overall
firm risk. But to repeat my point: effective communication is
an important element of the implementation.
Underfunding. The LT case is an example of a fully
funded plan with no surplus or deficit. If the firm were
underfunded, what might you want to consider? One possibility is to issue debt to fund the plan if you can. I’m not
going to comment on whether that’s the best strategy; the
only answer I can give is that it depends on the firm and its
circumstances. In making such a decision, some of the big
issues will include taxes, whether you are a profitable firm,
and how your communication with the rating agencies goes.
Funding the plan may well be the optimal decision—or you
may choose to fund the plan while making a change in the
asset mix of the pension. And, of course, debt and equity are
not the only possibilities for pension assets; there are other
assets, including all variety of derivatives.
Overfunding. If you have a surplus, what do you do?
Even if you want to match-fund the risk of what you owe,
do you take risk with the surplus and, if so, what kinds of
risk? Those are all part of the equation of what you need to
analyze when thinking about and implementing a policy.
There is no single answer for all cases.
Moving from a DB to a DC Plan
To those of you who decide that the answer is to end your
DB plan and start a DC plan, I offer some observations.
Suppose that an employee, upon retirement, would like to
receive a stream of income comparable to the one earned in
cannot in the future “dilute” the security of the current beneficiaries’ claims by either promising additional benefits in the future without immediately fully funding them or by changing
the investment policy of the fund. To my knowledge, neither of these future financing and
investment conditions is set either by employee contract or by ERISA law for typical U.S.
DB plans.
From a general equilibrium perspective, pension asset optimization should consider the
perspective of the firm and its shareholders as well as the beneficiaries of the plan in terms
of the “bargain” between the two since the equilibrium level of promised pension benefits
the firm will agree to is determined in part by the cost of providing those benefits, which
in turn depends on the terms of the arrangement between the firm and its beneficiaries. I
believe that over the past two decades, firms did not recognize how costly the benefits
they offered were at the time they agreed to them, but they do now; and as we see
››
A Morgan Stanley Publication • Winter 2006
23
the latter part of his or her working life in order to maintain
more or less the same standard of living. Although some
plans are more generous than others, the basic idea of a DB
plan is that it provides something near to one’s final income,
perhaps scaled down somewhat. When this arrangement
works, it’s wonderful because the employees do not need to
know anything; they simply have to believe it will happen,
and the benefits have to materialize at the appointed time.
With a DC plan, life becomes simpler for the corporation
in some ways. The moment it pays its fraction of income into
the plan, it has seemingly carried out all of its obligations. The
problem, however, is that in making this change, you are now
putting your employees in the position of having to make
some quite complex investment decisions. Imagine if you
were approached by a 42-year-old who told you he wanted to
retire at 67, and to have an income during retirement that was
roughly equal to 70% of his average earnings between the ages
of 62 and 67. What would you tell him he had to invest in
and how much he should be contributing in order to hit that
target? We do not even know today what that person will be
making in 20 years’ time, so this is quite a complex problem.
We do not ask people to do their own medical surgery,
or other kinds of important activities which require a great
deal of specialization. Yet, when addressing one of the most
important challenges in their lives, funding their retirements, employees in DC plans are essentially forced to
obtain advice that is typically based in large part on the
assumption that history will simply repeat itself. However,
a reasonable question for any of us as consumers to ask is,
“What happens if history does not repeat itself?”
What other major product do consumers buy where
they allow someone to hand them the product, tell them
this is an important part of their lives, and then warn them
that “If it does not work, it is your problem”? I am not just
pointing fingers, because I am also in this business. I do
not know the optimal solution, but I know that we can do
better than simply leave individuals to make these complex
decisions about risks.
That does not mean that DC plans are bad. What it does
suggest, however, is that DC plans as they are commonly
carried out today, particularly in the U.S., are not the long-run
answer. We have to design a product that works institutionally
from a DC plan, but has an output that looks more like a DB
plan. This kind of product is on the drawing board.
everywhere, they are rapidly closing their DB plans for new members and freezing them for
existing members.
No insurance company offers full-faith and credit of the U.S. government for its retirement annuity liabilities, even though very large AAA companies can be downgraded (AIG). In
principle, the market could provide full faith and credit annuities with individual segregated
accounts for each of its annuity participants. But it doesn’t, and I suspect that few customers would be so risk averse as to be willing to pay the high incremental cost to move from
AA-rated commingled funds of regulated insurers to segregated full-faith and credit asset
accounts. That is, for the bulk of retirees, the competitive market equilibrium is probably not
at that “corner solution” of extreme risk aversion.
To return to my original point, when one views the pension allocation decision in the
context of all the firm’s assets and all its liabilities—that is, when one practices ALM for the
entire firm—one can surely imagine a solution in which the optimal asset risk position in the
pension fund is not complete immunization and thus zero correlation with the exposure of
the firm’s net operating assets. In some cases, the optimal asset exposure could turn out
to be one that is negatively correlated with the operating assets of the firm, which in turn
would reduce the entire risk of the corporate asset base and improve the (implied) credit rat-
ing of the pension liabilities more effectively than simply holding debt securities with match
duration to the pension liabilities.
The limitation of immunization, then, is not that matching pension assets and liabilities will
fail to add value, but that it may not be the value-maximizing strategy. Since returns on equities, in the vast majority of cases, will be positively correlated with a firm’s operating assets,
holding equities in the pension fund is not likely to be an outcome of the firm-wide analysis
recommended here. Immunization-like positions in bonds or long-dated fixed rate swaps
will be an important part of the portfolio composition. However, when optimal tax, liquidity
considerations, and hedge accounting rules are taken into account, it is entirely possible
that the optimal pension asset mix could include significant holdings of alternatives like true
“zero-beta” hedge funds (which are often highly taxed if held on the corporate balance sheet)
and long-dated, illiquid equity put warrants on selected industries as well as interest rate,
currency, credit default swaps to offset “passive” exposures of the operating businesses.
(See my article, “You Have More Capital than You Think,” Harvard Business Review 83, no.
11 (November 2005): 84-94.)
In sum, I do not believe that in 2006 the optimal pension asset allocation decision should
be reduced to the “one size fits all” prescription of complete immunization.
24
Journal of Applied Corporate Finance • Volume 18 Number 1
Conclusion
Corporations today face huge challenges in managing DB
plans, and, if we go to the DC plans, there are huge challenges
there as well. When I worked at a large investment bank, we
had a focus group that aimed to design a great financial product for retired people. Focus groups were held all over the
U.S., and participants included non-profit institutions as well
as private corporations. The most common response from
participants when asked what they thought of our product
proposals was that “the products are too good to be true; we
do not believe it can happen.” But once we suggested that such
products might be made available through their employers,
their response was quite different: “Anything offered through
the employer plan has been scrubbed; it has been studied by
financial experts and lawyers. We trust our employers.”
I cannot imagine that the response would be much
different here in the UK. Consumers everywhere are looking
for solutions they can trust—and, by and large, they seem to
trust their employers. It is important to recognize that, with
a DC plan, the firm may eliminate—at least on paper—a lot
of risks and future obligations, but keep in mind that once
you change the plan to a DC, your employees will expect
you to have done a great job for them. If lots of people do
not receive in the future what they were promised, companies may find themselves making good, either voluntarily
or otherwise, on what prove to be the implicit obligations
associated with being a long-lived institution.
robert c. merton
is a co-founder and Chief Science Officer of
Integrated Finance Limited (IFL), a strategic advisory and pension-solutions firm, as well as John and Natty McArthur University Professor at
the Harvard Business School. He was awarded the 1997 Nobel Prize in
Economics for his contributions to modern finance, particularly in the
area of option pricing.
A Morgan Stanley Publication • Winter 2006
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